Assessing the relevance of the Basel III ratios - An empirical study using an option pricing default prediction model

Abstract: In the aftermath of the recent financial crisis, several shortcomings in the regulations of banks were revealed. As a response the Basel Committee on Banking Supervision presented a new standard, Basel III, with the aim of preventing future bank defaults. This study evaluates the relevance of four Basel III capital and liquidity ratios for reducing the probability of bank default. The investigated ratios are the tier 1 capital ratio, the leverage ratio, the liquidity coverage ratio and the net stable funding ratio. The empirical study includes 145 European and US banks over the time period 2006 to 2015. We model equity as a down-and-out call option on the bank's assets and obtain an annual default risk measure that considers default risk over time, dividend and coupon payments, as well as incorporates expected asset returns, as opposed to the risk-free rate. We then examine the association between the four Basel III ratios and the probability of default. Similar to previous research we are not able to find support for higher levels of the Basel ratios being associated with lower probabilities of default, which suggests that the Basel III capital and liquidity ratios might not be relevant for reducing default risk.